UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED JUNE 26, 2004

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM           TO

Commission File Number 0-27975

eLoyalty Corporation

150 Field Drive
Suite 250
Lake Forest, Illinois 60045
(847) 582-7000
(Address, Including Zip Code, and Telephone Number, Including Area Code, of
Registrant’s Principal Executive Offices)

     Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or Section 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes o No x

     The number of outstanding shares of the registrant’s common stock, $0.01 par value per share, as of August 3, 2004 was 7,175,109.

TABLE OF CONTENTS

Part I. Financial Information

Item 1. Financial Statements

eLoyalty Corporation
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited and in thousands, except share and per share data)

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of this financial information.

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eLoyalty Corporation
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited and in thousands, except per share data)

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of this financial information.

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eLoyalty Corporation
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited and in thousands)

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of this financial information.

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eLoyalty Corporation
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited and dollars in thousands, except per share data)

Note 1 — General

     In the opinion of management, the accompanying unaudited condensed consolidated financial statements of eLoyalty Corporation (we or eLoyalty) include all normal and recurring adjustments necessary for a fair presentation of our condensed consolidated financial position as of June 26, 2004, the condensed consolidated results of our operations for the three months and six months ended June 26, 2004 and June 28, 2003 and our condensed consolidated cash flows for the six months ended June 26, 2004 and June 28, 2003, and are in conformity with Securities and Exchange Commission (SEC) Rule 10-01 of Regulation S-X.

     The results of operations for any interim period are not necessarily indicative of the results for the full year. The accompanying financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto in our Annual Report on Form 10-K for the fiscal year ended December 27, 2003.

Note 2 — Severance and Related Costs

     Severance costs are comprised primarily of contractual salary and related fringe benefits over the severance payment period. Facility costs include losses on contractual lease commitments, net of estimated sublease recoveries, and impairment of leasehold improvements and certain office assets. Other costs include laptop costs, contractual computer lease termination costs, and employee related expenses.

     In 2003, in response to the business environment and decreased demand for IT consulting services, a number of cost reduction activities were undertaken, principally consisting of personnel reductions. These cost reduction activities were designed to size the workforce to meet eLoyalty’s expected business requirements. During the three months ended June 26, 2004 and June 28, 2003, respectively, eLoyalty recognized expense of $41 and pre-tax income of $149 related to these activities. The expense recorded in the second quarter of 2004 is primarily related to employee severance payments and related costs for the elimination of one position in the International segment. The $149 of income in the second quarter of 2003 primarily related to $416 of employee severance payments and related costs for the elimination of five positions, in both the North America and International segments, offset by adjustments of $234 following the favorable resolution of two matters involving former employees, $181 related to realized currency gains from transactions associated with the consolidation of our International operations and $150 related to adjustments of accruals for facility and other costs.

     For the six months ended June 26, 2004 and June 28, 2003, respectively, eLoyalty recognized income of $193 and expense of $1,111. The income in the first six months of 2004 is primarily related to a favorable settlement of employment litigation in the International segment partially offset by the elimination of one position in our International segment. The $1,111 expense in the first six months of 2003 is primarily related to $1,676 of employee severance payments and related costs for the elimination of 27 positions, offset by adjustments of $234 following the favorable resolution of two matters involving former employees, $181 related to realized currency gains from transactions associated with the consolidation of our International operations and $150 related to adjustments of accruals for facility and other costs.

     During the six months ended June 26, 2004, eLoyalty made cash payments of $1,720 related to cost reduction actions initiated in 2004 and earlier periods. eLoyalty expects substantially all severance and other charges to be paid out by the third quarter of 2004 pursuant to agreements entered into with affected employees. Facility costs related to office space reductions and office closures, reserved for in 2002 and 2001, are to be paid pursuant to contractual lease terms through 2007 and other costs are to be paid pursuant to contractual commitments through the third quarter of 2004.

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     Reserves for severance and related costs and their utilization for the six months ended June 26, 2004 are as follows:

     Of the $1,722 that remained reserved as of June 26, 2004, $859 related to future lease payments, net of estimated sublease recoveries, is recorded in “Long-term liabilities,” $142 related to employee severance payments is recorded in “Accrued compensation and related costs” and the balance of $721 is recorded in “Other current liabilities.” Of the balance in “Other current liabilities,” $605 relates to facility lease payments, net of estimated sublease recoveries, and is expected to be paid over the next twelve months.

Note 3 — Comprehensive Net Loss

     Comprehensive net loss is comprised of the following:

     The accumulated other comprehensive loss, which represents the cumulative effect of foreign currency translation adjustments, was $3.9 million and $3.8 million at June 26, 2004 and December 27, 2003, respectively.

Note 4 — Loss Per Share

     The following table sets forth the computation of the loss and shares used in the calculation of basic and diluted loss per share:

     In periods in which there is a loss, the dilutive effect of common stock equivalents, which is primarily related to the 7% Series B Convertible Preferred Stock, was not included in the diluted loss per share calculation as it was antidilutive. The total number of common share equivalents that would have been included in the computation of diluted loss per share if they had been dilutive was 4,593 and 4,018 for the three months ended June 26, 2004 and June 28, 2003, respectively, and 4,488 and 4,144 for the six months ended June 26, 2004 and June 28, 2003, respectively.

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Note 5 — Segment Information

     eLoyalty focuses exclusively on providing customer relationship management (“CRM”) related professional services. eLoyalty has two reportable geographic segments: North America (consisting of US and Canada) and International. The following table reflects revenue and operating results by reportable segment for the three months and six months ended June 26, 2004 and June 28, 2003, respectively, and total assets by reportable segment as of June 26, 2004 and December 27, 2003, respectively.

     Total long-lived assets for US operations are $10,071 and $11,236 at June 26, 2004 and December 27, 2003, respectively. For the three months ended June 26, 2004 and June 28, 2003, Consulting services represented 76% and 82% of total revenue, Managed services represented 14% and 11% of total revenue and sales of third-party software represented 2% and less than 1% of total revenue, respectively. Reimbursed expenses represented 8% and 7% of total revenue for the three months ended June 26, 2004 and June 28, 2003, respectively. For the six months ended June 26, 2004 and June 28, 2003, Consulting services represented 74% and 80% of total revenue, Managed services represented 16% and 11% of total revenue and sales of third-party software represented 3% and 3% of total revenue, respectively. Reimbursed expenses represented 7% and 6% of total revenue for the six months ended June 26, 2004 and June 28, 2003, respectively.

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Note 6 — Stock Based Compensation

     eLoyalty accounts for stock-based compensation using Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” whereby compensation cost for stock options is measured as the excess, if any, of the fair market value of a share of the Company’s stock at the date of grant over the amount that must be paid to acquire the stock. Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” issued subsequent to APB No. 25 and amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” defines a fair value-based method of accounting for employee stock options but allows companies to continue to measure compensation cost for employee stock options using the intrinsic value-based method described in APB No. 25.

     The following table illustrates the effect on net loss available to common stockholders and net loss per share if eLoyalty had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” to stock-based employee compensation. No compensation costs have been recognized for the stock option plans. Compensation costs were recognized for restricted and installment awards as expense in the Condensed Consolidated Statements of Operations.

Note 7 — Recent Accounting Pronouncements

     In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 03-6, “Participating Securities and the Two-Class Method under Financial Accounting Standards Board (“FASB”) Statement No. 128, Earnings per Share.” EITF 03-6 clarifies what constitutes a participating security and provides further guidance in applying the two-class method of calculating earnings per share (“EPS”). The consensus reached by the Task Force in this Issue is effective for reporting periods beginning after March 31, 2004. eLoyalty adopted EITF Issue No. 03-06 in the quarter

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ended June 26, 2004. There was no impact of the adoption on the computation of EPS during the three months and six months ended June 26, 2004, as the effect is antidilutive. In periods of net income, eLoyalty will utilize the two-class method of computing EPS.

Note 8 — Litigation and Other Contingencies

     eLoyalty, from time to time, has been subject to legal claims arising in connection with its business. While the results of these claims cannot be predicted with certainty, at June 26, 2004 there were no asserted claims against eLoyalty that, in the opinion of management, if adversely decided, would have a material effect on eLoyalty’s financial position, results of operations, and cash flows.

     eLoyalty is a party to various agreements, including substantially all major services agreements and intellectual property licensing agreements, under which it may be obligated to indemnify the other party with respect to certain matters, including, but not limited to, indemnification against third party claims of infringement of intellectual property rights with respect to software and other deliverables provided by us in the course of our engagements. These obligations may be subject to various limitations on the remedies available to the other party, including, without limitation, limits on the amounts recoverable and the time during which claims may be made, and may be supported by indemnities given to eLoyalty by applicable third parties. Payment by eLoyalty under these indemnification clauses is generally subject to the other party making a claim that is subject to challenge by eLoyalty and dispute resolution procedures specified in the particular agreement. Historically, eLoyalty has not been obligated to pay any claim for indemnification under its agreements and, as of June 26, 2004, management was not aware of future indemnification payments that it would be obligated to make.

Note 9 — Subsequent Event

     In July 2004, the Company completed the acquisition of substantially all of the assets of Interelate, Inc., a provider of customer analytics solutions that enable clients to acquire, retain and grow customers. In connection with the acquisition, eLoyalty paid Interelate a cash purchase price of $4,900 and a cash payment equal to Interelate’s estimated working capital at closing of approximately $500 (subject to post-closing adjustment), and assumed certain specified liabilities of Interelate.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

     The following Management’s Discussion and Analysis and other parts of this Form 10-Q contain forwa